King of the Economy

By

Gene Epstein

Updated March 15, 1999 12:01 a.m. ET

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Y ou know why people climb Mount Everest: Because it's there. Well, the same one-liner helps account for the widespread impression that the bull market in equities is somehow propping up the economy: Because it's also there. After all, the logic goes, total market value stands at more than 150% of gross domestic product (not "more than 30%" of GDP, as I absentmindedly and egregiously wrote in my March 1 column ) and big events must have big effects. Contrariwise, a bear market presumably will push the expansion into recession.

A couple of weeks ago, I argued that the bull market fell far short of holding the nation's economic fate between its hooves. But then a brace of critics rejected such assurances, arguing in effect that I was blinding myself to the prepossessing influence of this elephant in the room.

So herewith another go at the issue, beginning with the same disaster scenario I mentioned the first time around. To pose again the question that must seem odd against the market action of the past week, what would happen if the market averages declined 30% and remained there for a year?

Growth in consumption would lose some of of its edge. Here I'm referring to the time-honored wealth effect, which says that people spend more when their wealth rises and less when it falls. Jason Benderly of Vail, Colorado-based Benderly Economics estimates that this effect is now worth about a penny on the dollar. That is, consumption rises or falls by one cent in response to a dollar's worth of fluctuation in investor holdings.

For sure, a 30% bear market amounts to a lot of dollars, but a penny's worth of hit still amounts to a modest drag on consumption growth. My critics who trotted out the "this-time-is-different" argument missed a crucial point. One factor that's different now is that much of the market's rise has boosted consumer buying by less than in the past. And that's because prices have risen too far and too fast to have anything more than a negligible effect on behavior.

My critics give the average investor a lot less credit for common sense than they would give themselves. I know someone who's worth a million on paper from investing in high-techs. But I see no evidence of his suddenly redefining himself as a millionaire and spending accordingly. Maybe he'll feel that way in a few years, but certainly not now. So if the value of his portfolio plummets by 60%, his buying habits won't change a bit, since they weren't altered in the first place.

Regarding the wealth effect, I also pointed out that the very rich are immune to a bear market. Since they consume no more than one-half to two-thirds of their incomes to begin with, even big investment losses won't force them to tighten their belts at all.

But in this case, I showed poor judgment in using Bill Gates as an example. I actually meant not just the out-of-sight rich, but your garden variety very rich pulling down several hundred thousand a year.

My critics also took me to task for not mentioning other fallout from a bear market. Lots of employees from the securities industry might lose their jobs, not to mention members of the financial press. Some of the edge would be taken off the high end of the housing market. All bad news, but not disastrous. Consumer confidence would temporarily suffer. But unless economy-wide employment gains were hurt severely, confidence would soon bounce back.

College endowments, foundation and insurance company portfolios would decline in value. But here, too, their windfalls probably didn't alter their practices by very much, so the loss of those windfalls wouldn't hurt them much, either.

Tax revenues would also suffer a bit for lack of realized capital gains. But this effect might be muted if trading volume increases on the way down. Indeed, if a lot of investors who bought in a while back start to sell, then capital-gains realizations might swell government coffers even more than usual.

All of this is why Benderly estimates that the 30% bear market would shave about a percentage point off economic growth. So if growth continues to be robust at 3.5% per year, it would decline to a still-decent 2.5%.

Finally, my critics asked, if the bull market hasn't fueled this surprisingly strong expansion, just what has? As Benderly has found, it's mainly the surge in real hourly earnings, which has been growing at the highest rate in more than 30 years. This is what has brought accelerating consumption growth for the vast majority of households in the U.S. who happen to own little or no stock. It's the real elephant in the room, and its future course is a lot more important to the economy than the fate of equities.

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